Wayne’s Fizzer Underwhelms Analysts

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By Greg Peel

“The reforms do appear quite hostile to the big banking industry with the government regularly forming assertions on major banks without reference to external data,” said the BA-Merrill Lynch bank analysts this morning. Allow me licence to provide a colloquial translation, unendorsed by Merrills:

“Those idiots in Canberra are quite simply clueless and would do well to actually research the topic upon which they are making populist policy decisions”.

Over the past couple of weeks the market has been selling down the Big Four banks and buying up regionals and smaller institutions in expectation that the government was about to shake up competition in Australia's retail banking industry in a big way. Leading the policy drive (no doubt) has been a focus group in one of Australia's swinging, mortgage belt electorates. But not only are the policy proposals announced unlikely to impact in the government's desired fashion, they've largely gone the other way.

Not that there's anything much wrong with the proposals, it's just that the anticipated shift in competitive advantage away from the Big Four – which control 90% of all Australian mortgages thanks to the government's GFC reaction – and onto other lenders will not result. As for Treasurer Wayne Swan's big push for a “fifth pillar” of banking in the form of the “mutuals” – credit unions, building societies and the like – well that just seems to have been missed.

It was Paul Keating – who deregulated the banking industry and gave us the “four pillars” in the first place – who once famously said that a parliamentary attack from Opposition leader John Hewson was like being hit over the head with a wet newspaper. That's probably how the Big Four were feeling yesterday.

There were 13 reforms in the package. Those of most significance were: the banning of exit fees on new home loans; a review of account portability; more oversight on credit cards, ATM fees and price signalling; the FCS to be made permanent from October; an additional $4bn of AOFM support for RMBS; and the introduction of covered bonds. Let's first unravel the jargon on those last three.

The Financial Claims Scheme (FCS) refers to the policy move the government made on the fall of Lehman to guarantee bank deposits up to a limit. This was set to expire but under the new proposal it won't, albeit the limit of guarantee thereafter is yet to be determined.

The Australian Office of Financial Management (AOFM) is that which actually handles the government's debt financing, including issuing bonds and so forth. Another previous policy was for the AOFM to provide support to Australia's residential mortgage-backed securities market (RMBS) which had shut down in the GFC, to the tune of $16bn. That support has now been upped to $20bn.

Readers may shudder to recall that the GFC itself was brought about (not solely but finally) by the collapse of the mortgage security market in the US. But the problems here related to the proportion of “subprime” mortgages securitised, the financial derivatives which were designed around them (collaterlised debt obligations or CDOs), the AAA ratings clueless credit agencies were paid to rate those securities, and the subsequent credit default swaps (CDS) written on them. All of the above was a US-centric confluence which never made it meaningfully across the Pacific.

The reality is RMBS, when respected and not exploited, are a valuable source of lower cost bank funding and a solid investment for fund managers. Quite simply RMBS allows indirect investment in “bricks and mortar” as an asset class through pooling and on-selling mortgage exposures. They also increase competition in mortgages, as John Symond and co would attest. Before the GFC, smaller institutions (including St George, for example) relied on RMBS for funding because they didn't have the credit ratings of the Big Four, which were able to access offshore funding as a result.

As a result of the GFC, the RMBS market died across the globe, unsurprisingly, leaving smaller institutions high and dry and sending all mortgages the Big Four's way, aided by government hand-outs. That's why we're at this (ironic) point of at which the government is desperately trying to rekindle banking sector competition to appease the masses.

A “covered bond” is similar to an RMBS in that it represents the packaging up of assets such as mortgages or other loans for on-sale to the investment market. The difference, however, is that while RMBS and other equivalent instruments are packaged up by the banks and then sold off to new owners, the loans behind a covered bond remain on the bank's balance sheet. What you are thus buying by investing in a covered bond is not a slice of a bunch of mortgages, but a slice of the income stream from those mortgages. Again it is somewhat ironic that covered bonds have not previously been allowed in Australia, yet securitisation had been warmly embraced.

Now – what's the impact?

Well the exit fee thing was a definite fizzer. As we know, ANZ ((ANZ)) and National ((NAB)) had already done away with exit fees anyway. The expectation is that exit fees would be banned for all loans, but they've only been banned for new loans. The cost to the big banks will be immaterial, analysts suggest. The impact on the smaller institutions will actually be negative, as cheap loans at the front end are subsidised by such fees, allowing the littlies to compete with the funding-advantaged big banks.

So far anything to do with account portability and price signalling restrictions remains at the motherhood statement level, so what happens now is unclear. Credit Suisse notes that improving account portability may actually place a new IT cost burden on the smaller banks.

Were it not for some form of FCS insurance, depositors would prefer those banks with better credit ratings, notes JP Morgan. So that's a plus for the smaller banks, albeit it depends on limits, structure and fees to the banks which are, again, unclear at this point.

Bumping up RMBS support is fine, but covered bonds will actually provide a cheaper alternative funding source for the bigger banks – the ones with all the mortgages. So this really is a clear plus for the Big Four. It might help ease the cost of a mortgage, but it will not much assist competition.

Morgan Stanley estimates the Big Four could see 1-6 basis points of margin relief from covered bonds, affecting profit increases of 1-4% over time. JP Morgan suggests that the covered bond proposal may yet backfire to a degree because under the new Basel III regulations, Australian banks will be required to hold more liquid assets. Lack of government bonds is a problem, covered bonds would substitute, and so what may transpire is that the Big Four simply all buy each other's bonds. The only real relief would come from substituting for offshore corporate bond issues.

So that's a review of what has been proposed, and all bank analysts agree the Big Four can have a relaxing summer holiday while the littlies despair on what might have been. Perhaps what is more glaring in the policy package, however, is that which isn't there.

There was no talk of using Australia Post as a banking service. Probably a good thing since Australia once had a national government bank – the Commonwealth (CBA)) – but sold it. Postbank would have looked a bit silly.

There were no considerations given to risk weighting changes or the treatment of franking credits, as Deutsche Bank notes, but then that's probably a bit of a tough one for politicians. Most surprisingly, there was nothing in the package to support the “mutuals” – no wholesale guarantees or other means to improve distribution. So much for the “fifth pillar”. The impact for mortgage brokers is also unclear.

Citi notes, “Mutuals do not have the size, scope and expertise to compete effectively with the major banks in the foreseeable future”.

As the market's reaction to the package indicates (yesterday the big banks were bought and the small banks sold), Swan's proposals are not nearly as onerous as the market, or analysts, had feared.

Which, of course, has opened the door for the Opposition to attack the proposals as weak, for the Greens to insist on steeper measures such as ATM fee review, and for the independents to throw the rural hat into the ring. In other words, like every piece of proposed legislation that will hit parliament in 2011, there are no guarantees of passage and plenty of scope for heated debate and stalemates.

Such is Australia.

No changes of any note in analyst bank ratings or forecasts have emanated from these policy proposals (though Citi does have both regional lenders now on Sell and Morgan Stanley also downgraded Bendigo and Adelaide Bank ((BEN)) today).

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